Friday, December 19, 2008

US public finance arena sags beneath the headwinds

--2.6 tril muni credit market broke down, especially the 330 bil ARS component.
--Credit derivatives priced higher risk of default for thos de facto AAA 50k issuers than IG corp issuers.
--a backlog of more than 100 bil in postponed issuance is spilling into 2009.
--Fed has to step in, impling the federalism and local autonomy
US public finance arena sags beneath the headwinds
By Nicole Bullock in New York
Published: December 19 2008 02:00 Last updated: December 19 2008 02:00
In the span of one gut-wrenching month this year, Frank Hoadley saw his interest costs triple to as much as 15 per cent.
Mr Hoadley, the capital finance director for the state of Wisconsin, was not alone. State and local finance departments across the US were hit with an abrupt spike in borrowing rates as the so-called auction-rate securities market, a $330bn component of the municipal bond market, collapsed in February.
It was the opening shot in a year when the public finance market, a $2,600bn arena where state and local entities raise money for everything from roads and bridges to schools and airports, broke down completely. "Every day you told yourself: this is as bad as it gets," Mr Hoadley says, "and the next day it got worse. And, that continues today. New surprises keep popping out of the woodwork."
Traditionally, municipal bonds were a dusty, drab corner of the financial markets. Returns were fairly predictable and the investor base was mostly individual US savers. The 50,000 odd issuers, though ranging from the local fire department to the state of New York, were homogenised through the widespread use of insurance, which gave much of the market a de facto AAA rating.
As 2008 would demonstrate, municipals became as mired in the excesses of the boom years as the rest of the credit markets, if not more. "A few years ago, there was a lot of complacency in our market," says Mark Sommer, a portfolio manager at Fidelity Investments. "All that has evaporated."
With a loss of 7.6 per cent, munis are on track for their worst year ever, according to Merrill Lynch. Auction-rate securities, which had been a source of cheap funding for many issuers, have disappeared. Long-term borrowing costs even for top-rated, AAA municipalities have risen to nearly 6 per cent, an eight-year high, and a backlog of more than $100bn in postponed bond sales is spilling into 2009.
It is hard to find a corner of the credit market that is not in disarray. What makes munis unique is that they are one of the main sources of financing for essential public services throughout the US. That financing is now much more expensive or not available at all.
"Without access to long-term capital on their own, state and local governments would need to rely on the federal government for funding, and that has all kinds of implications for federalism and local autonomy," says Matt Fabian, managing director of Municipal Market Advisors. The trouble began when it emerged that big muni bond insurers, such as MBIA and Ambac, had also written similar policies on risky mortgage debt. When the mortgage market cracked, so did the so-called monolines, prompting a massive repricing of muni debt to the issuers' underlying ratings. It also upset financing arrangements like auction rate securities.
"It was the perfect storm of a lot of seemingly independent events being very related," says Lynnette Hotchkiss, executive director of the Municipal Securities Rulemaking Board, the industry trade group.
At the same time, hedge funds, a source of new demand in recent years, became sellers, unleashing huge supply on an already bruised market. The final blow came with the bankruptcy of Lehman Brothers, which drained liquidity from the whole financial system.
Lured by the high relative yields, retail investors have stepped in, but they lack the deep pockets to absorb rising issuance.
"This is a market that we have not seen in munis for 10 years," says Philip Fischer, municipal strategist at Merrill Lynch. "We are happy to work with retail clients, but we need more buyers."
The market is expected to remain under pressure in 2009. With the US in a recession, states and local governments are facing growing budget deficits. The US government appears to favour stimulus for state and local economies over direct aid and the credit derivatives market is pricing in a greater risk of default than for high-grade corporate bonds.
"There are a lot of headwinds," Mr Sommer of Fidelity says. "Muni bond prices are reflecting investors' skittishness, scepticism and fear about how this will play out."
This article is the second in a series